Chapter 4 Financial Market: 1 Reference: Macroeconomics, Blanchard 5/e Updated

Chapter 4 Financial Market
1
Reference: Macroeconomics, Blanchard
5/e Updated
1. The Demand for Money
(1) Semantic traps:
Income: is what you earn from working plus
what your receive in interest and dividends.
It is a flow variable something expressed in
units of time weekly income, monthly
income, or yearly income. For example, J.
Paul Getty was once asked what his income
was . Getty answered: $1000. He meant,
but did not say, $1000 per minute!
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Saving: is part of disposable income that you
do not spend. Y T C. It is also a flow
variable. If you save 10% of your income, and
your income is $3000 per month, then you
save $300 per month.
Savings: is sometimes used as a synonym for
wealth the value of what you have
accumulated over time.
(Financial) wealth: is the value of all your
financial assets minus all your financial
liabilities. It is a stock variable. It is the value
of wealth at a given moment in time.
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Money: Financial assets that can be used
directly to buy goods and services are called
money. Money includes currency and
checkable deposits. Money is a stock variable.
Investment: is a term economists reserved for
the purchase of new capital goods, from
machines to plants to office buildings. When
you want to talk about the purchase of shares
or other financial assets, you should refer
them as a financial investment.
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(2) How to allocate wealth between money and bonds?
Suppose your financial wealth today is $50,000. You may
intend to keep saving in the future and increase your
wealth further, but its value today is given. Suppose also
that you only have the choice between two assets, money
and bonds.
Money: pays no interest. You can use it for transactions.
Bonds: pays a positive interest rate, i. But you can not use
them for transactions. In the real world, there are many
types of bonds, each associated with a specific interest
rate. We will simply assume that there is just one type of
bond and that it pays, i, the rate of interest. (MMMF)

How much of your $50,000 should you hold in money and
how much in bonds?
All in money. All in bonds. If should hold both money and
bonds, how much money?
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(3) Determinants of your demand for money
Your level of transactions: you will want to
have enough money on hand to avoid having
to sell bonds too often.
The interest rate on bonds: the reason to hold
bonds is that they pay interest. The higher the
interest rate, the more you will be willing to
hold bonds, the less you will be willing to hold
money. (money market accounts in early
1980s)

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(4) Deriving the equation of the demand for money for
the economy, M
d
:
Overall level of transactions: The demand for money in
the economy as a whole depends on the sum of all the
individual transaction demands for money. The overall
level of transactions in the economy is hard to
measure, but it is likely to be proportional to nominal
GDP, denoted by $Y.
M
d
| as $Y|. (M
d
and $Y are positively related.)
The interest rate on bonds: the reason to hold bonds is
that they pay interest. The higher the interest rate, the
more we all will be willing to hold bonds, and the less
we all will be willing to hold money.
M
d
+ as i|. (M
d
and i are negatively related.)

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The equation of the demand for money for the economy:

Read this equation in the following way:
The demand for money, M
d
, is equal to nominal income, $Y,
times a function of the interest rate, i, with the function
denoted by L(i ).
The demand for money:
-- M
d
| as $Y|. (M
d
and $Y are positively related.)
-- M
d
+ as i|. (M
d
and i are negatively related.)
The graph of the demand for money for the economy:
Given $Y, M
d
+ as i|. A movement up along the M
d
curve.
Given $Y, M
d
| as i+. A movement down along the M
d
curve.
Given i, M
d
| as $Y|. A shift out of the M
d
curve.
Given i, M
d
+ as $Y+. A shift in of the M
d
curve.
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$ ( )
d
M Y L i =
( )

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Figure 4-1 The demand for money
2. The Supply of Money and
Determining the interest rate, i
(1) The supply of money
In the real world, there are two types of
money, currency, which is supplied by the
central bank, and checkable deposits, which
are supplied by banks. For this moment, we
assume the only money in the economy is
currency. Suppose that the central bank
decides to supply an amount of money equal
to M, which is independent of interest rate, so
M
S
=M.
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(2) Money demand, money supply and the
equilibrium interest rate
Equilibrium in financial markets requires that
money supply be equal to money demand
M
S
=M
d

M=$Y L(i)
This equation tells us that the interest rate i,
must be such that, given income, people are
willing to hold an amount of money equal to
the existing money supply. This equilibrium
relation is called the LM relation. Graphically

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Figure 4-2 The determination of the equilibrium interest rate
(3) Changes in equilibrium and equilibrium interest rate:

The effects of an increase in nominal income on the
equilibrium interest rate:
$Y|M
d
curve shifts outi|
Reason: At the initial interest rate, M
d
>M
S
. An increase in
the interest rate is needed to decrease the amount of
money people want to hold and to reestablish equilibrium.

The effects of an increase in the money supply on the
equilibrium interest rate:
M
S
|M
S
curve shifts outi+
Reason: At the initial interest rate, M
d
<M
S
. A decrease in
the interest rate is needed to increase the amount of
money people want to hold and to reestablish equilibrium.
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14 Figure 4-3 The effect of an increase in nominal income on the interest rate
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15 Figure 4-4 The effect of an increase in the money supply on the interest rate
(4) Monetary policy and open market operations
Recall that currency is supplied by the central bank, so
how the central bank actually changes the money
supply.
Open market operations
In modern economics, the way central banks change
the supply of money is by buying and selling bonds in
the bond market.
-- If a central bank wants to increase M
S
, it buys bonds
and pays for them by creating money.
-- If a central bank wants to decrease M
S
, it sells bonds
and removes from circulation the money it receives in
exchange for the bonds.
-- These actions are called open market operations,
expansionary for the former and contractionary for the
latter.
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-- The balance sheet of the central bank:
The assets of the central bank are the bonds it
holds in its portfolio. Its liabilities are the stock
of money in the economy. Open market
operations lead to equal changes in assets and
liabilities. For example, if the central bank
buys, say, $1 million worth of bonds, the
amount of bonds it holds is higher by $1
million, and so is the amount of money in the
economy. Such an operation is called an
expansionary open market operation.
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Figure 4-5 The balance sheet of the central bank and the effects of an expansionary
open market operation
Bond prices and bond yields
We havent discussed a lot about the interest rate on
bonds. In fact, what is determined in bond markets is
not interest rates but bond prices; the interest rate on
a bond can then be inferred from the price of the
bond. Suppose the bonds in our economy are one-year
bonds bonds that promise a payment of a given
number of dollars, say, $100, one year from now. In the
United States, bonds issued by the government
promising payment in a year or less are called Treasury
bills, or T-bills. Let the price of a bond today be $P
B
. If
you buy the bond today and hold it for a year, the rate
of return on holding the bond for a year is ($100-$P
B
)/
$P
B
. Therefore, the interest rate on the bond is given by
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If $P
B
=$95, i=0.053=5.3%
If $P
B
=$90, i=0.111=11.1%
The higher the price of the bond, the lower the interest
rate.
If we are given the interest rate, we can figure out the
price of the bond using the same formula. Reorganizing
the formula above, then

The higher the interest rate, the lower the price of the
bond today. So $P
B
and i are negatively related.
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i
P
P
B
B
=
$100 $
$
$
$100
P
i
B
=
+ 1
An expansionary open market operation
revisited:
Central bank buys bonds in the bond market and
pays for them by creating money. As the central
bank buys bonds, the demand for bonds goes up,
increasing their price. Conversely, the interest
rate on bonds goes down.
A contractionary open market operation
revisited:
Central bank sells bonds in the bond market and
removes money from circulation. As the central
bank sells bonds, the supply of bonds goes up,
decreasing their price. Conversely, the interest
rate on bonds goes up.
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(5) Choosing money or
choosing the interest rate?
Choosing interest rate
because this is what
modern central banks,
including the Fed, typically
do. They typically think
about the interest rate they
want to achieve and then
move the money supply so
as to achieve it. Figure 4-4
could also be used to
describe that the central
bank decides to lower the
interest rate by increasing
the money supply.
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Figure 4-4 The effect of an increase in the
money supply on the interest rate
(6) Money, bonds, and other assets
We have been looking at an economy with only
two assets: money and bonds. This is obviously
a much simplified version of actual economies,
with their many financial assets and many
financial markets.

There is one dimension, however, to which our
model must be extended. We have assumed that
all money in the economy consists of currency
supplied by the central bank. In the real world,
money includes not only currency but also
checkable deposits.

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3. The Determination of Interest Rate, ii*
(1) What banks do
To understand what determines the interest rate in an
economy with both currency and checkable deposits, we must
look at what banks do. Modern economies are characterized by
the existence of many types of financial intermediaries.
-- Financial intermediaries are institutions that receive funds
from people and firms and use those funds to buy financial
assets or to make loans to other people and firms.
-- The assets: are the financial assets they own and loans they
have made.
-- The liabilities: are what they owe to the people and firms
from whom they have received funds.
-- Banks are one type of financial intermediary. What makes
banks special is that their liabilities are money checkable
deposits.
-- The balance sheet of banks
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Figure 4-6 (b):
Liabilities: people and
firms either deposit
funds directly or have
funds sent to their
checking accounts. The
liabilities of the banks
are equal to the value
of these checkable
deposits.
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Figure 4-6 The balance sheet of banks and
The balance sheet of the central bank revisited
Figure 4-6 (b):
Assets: banks keep as reserves
some of the funds they receive.
The reserves are held partly in
cash and partly in an account the
banks have at the central bank,
which they can draw on when
they need to. Banks hold reserves
for three reasons: (1)
precautionary to meet
withdrawal purposes. (2)
precautionary to meet clearing
purposes. (3) regulatory to meet
central banks reserve
requirements, which say that
they MUST hold reserves in some
proportion of their checkable
deposits. The ratio of bank
reserves to bank checkable
deposits is about 10% in the U.S.
Banks can use the other 90% to
make loans or buy bonds.
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Figure 4-6 (b):
Assets: loans represents
roughly 70% of banks
nonreserve assets. Bonds
account or the rest 30%.
The distinction between
bonds and loans is
unimportant for our
purpose which is to
understand how the
money supply is
determined. For this
reason, we will assume
that banks do not make
loans and that they hold
only reserves and bonds
as assets.
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But the distinction between loans and bonds
is important for other purposes, from the
possibility of bank runs to the role of federal
deposit insurance. See Focus on page 74.
Figure 4-6 (a):
Assets: are the bonds it
holds.
Liabilities: are the
money it has issued,
central bank money.
The new feature is that
not all central bank
money is held as
currency by the public.
Some of it is held as
reserves by banks.
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(2) The supply and the demand for central bank money
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Figure 4-7 Determinants of the demand and the supply of central bank money
The demand for money by people is for both checkable deposits and currency. Because
banks have to hold reserves against checkable deposits, the demand for checkable
deposits leads to a demand for reserves by banks. Consequently, the demand for central
bank money is equal to the demand for reserves by banks plus the demand for currency.
The supply of central bank money is determined by the central bank. The interest rate
must be such that the demand and the supply of central bank money are equal.
The demand for money:

The demand for currency:

The demand for checkable deposits:

where c represents that people hold a fixed
proportion of their money in currency. In the
United States, c = 40%. People hold 40% of their
money in the form of currency, therefore, 60% of
their money in checkable deposits.

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d d
CU c M =
D c M
d d
= ( ) 1
The demand for bank reserves:
The relation between reserves (R) and deposits (D):

where u is the reserve ratio.
The demand for reserves by banks is given by:

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R D u =
( )
1
d d
R c M u =
The demand for central bank money:

Call H
d
the demand for central bank money. This
demand is equal to the sum of the demand for
currency and the demand for reserves.

The supply of central bank money:
Let H be the supply of central bank money. The
central bank can change the amount of H through
open market operations.
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H CU R
d d d
= +
( ) ( )
1 1
d d d d
H cM c M c c M u u = + = + (

( ) ( )
1 $
d
H c c Y L i u = + (

The supply and the demand for central bank money:

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Figure 4-7 Determinants of the demand and the supply of central bank money
(3) The determination of the interest rate
Equilibrium interest rate:
In equilibrium, the supply of central bank money (H) is
equal to the demand for central bank money (H
d
):

Or restated as:
H = [c+u(1-c)]$YL(i)
Note: As long as people hold some checkable deposits
(0<c<1), the term in brackets is less than 1. This means
that the demand for central bank money is less than
the overall demand for money. This is due to the fact
that the demand for reserves by banks is only a
fraction of the demand for checkable deposits.
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H H
d
=
The determination of
the interest rate:
The equilibrium interest
rate is such that the
supply of central bank
money is equal to the
demand for central
bank money.

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Figure 4-8 Equilibrium in the market for
central bank money and the determination
of the interest rate
4. Two alternative ways of looking at the equilibrium
(1) The federal funds market and the federal funds rate
The supply and the demand for bank reserves:

This alternative way of looking at the equilibrium is
attractive because, in the United States, there is indeed an
actual market for bank reserves, where interest rate moves
up and down to balance the supply and demand for
reserves. This market is called the federal funds market.
Banks that have excess reserves at the end of the day lend
them to banks that have insufficient reserves. In
equilibrium, .

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The left hand side: The supply of reserves is equal to the supply of
central bank money, H, minus the demand for currency by the public, CU
d
.
H CU R
d d
=
H CU R
d d
=
The federal funds rate:
The interest rate determined in this market is
called the federal funds rate. Because the Fed
can in effect choose the federal funds rate it
wants by changing the supply of central bank
money, H, the federal funds rate is typically
thought of as the main indicator of U.S.
monetary policy. This is why so much
attention is focused on it and why changes in
the federal funds rate typically make front-
page news.
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Source: http://www.stlouisfed.org/.
(2) The supply of money, the demand for money, and
the money multiplier
We can think of the equilibrium in terms of the equality of the supply and demand of
central bank money, or in terms of the equality of the supply and demand of reserves.
There is yet another way of thinking about the equilibrium in terms of the equality of
the overall supply and the overall demand for money (currency and checkable
deposits).

Supply of money = Demand for money
The overall supply of money is equal to central bank
money times the money multiplier:

High-powered money is the term used to reflect the
fact that the overall supply of money depends in the
end on the amount of central bank money (H), or
monetary base.

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1
$ ( )
[ (1 )]
H Y L i
c c u
=
+
( ) ( )
1/ 1 c c u +
(3) Understanding the money multiplier
For simplicity, set c=0 and u=0.1. The
multiplier=10. (Implication: people hold only
checkable deposits, reserve ratio equals 0.1.) An
increase of $100 of high-powered money leads to
an increase of $1000 in the money supply. How
the initial increase in central bank money leads to
a tenfold increase in the overall money supply?

Suppose the Fed buys $100 worth of bonds in an
open market operation. It pays the seller Seller
1 - $100. To pay Seller 1, the Fed creates $100 in
central bank money. The increase in central bank
money is $100.

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Seller 1 deposits the $100 in a checking account at his bank bank
A. This leads to an increase in checkable deposits of $100.
Bank A keeps $100*0.1=$10 in reserves and buys bonds with the
rest $100*(1-0.1) . It pays $100*(1-0.1) to the seller of those bonds
call her Seller 2.
Seller 2 deposits $100*(1-0.1) in a checking account at her bank
bank B. This leads to an increase in checkable deposits of $100*(1-
0.1).
Bank B keeps $100*(1-0.1)*0.1 in reserves and buys bonds with the
rest $100*(1-0.1)*(1-0.1), that is $100*(1-0.1)
2
. It pays $100*(1-
0.1)
2
to the seller of those bonds call him Seller 3.
Seller 3 deposits $100*(1-0.1)
2
in a checking account at his bank
bank C. This leads to an increase in checkable deposits of $100*(1-
0.1)
2
.
Bank C keeps $100*(1-0.1)
2
*0.1 in reserve and buys bonds with the
rest $100 *(1-0.1)
2
*(1-0.1), that is $100*(1-0.1)
3
. It pays $100*(1-
0.1)
3
to the seller of those bonds call her Seller 4.

$100+ $100*(1-0.1) + $100*(1-0.1)
2
+ = $1000

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We can think of the ultimate increase in the
money supply as the result of successive
rounds of purchases of bondsthe first
started by the Fed in its open market
operation, the following rounds by banks.
Each successive round leads to an increase in
the money supply, and eventually the increase
in the money supply is equal to 1/u
times the initial increase in the central bank
money.
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Chapter 4 Financial Market: 1 Reference: Macroeconomics, Blanchard 5/e Updated

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Chapter 4 Financial Market

Reference: Macroeconomics, Blanchard

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